Investors who wish to gain exposure to commodities can do so directly through futures, options and other derivatives; or indirectly, and perhaps unintentionally, through the currencies of commodity exporting nations. The Australian dollar (AUD), Canadian dollar (CAD), Brazilian real (BRL), Mexican peso (MXN), Russian ruble (RUB) and the South African rand (ZAR) demonstrate positive and, at times, reasonably strong correlations to a large basket of commodities. (Figure 1).
|West Texas Intermediate Crude Oil||0.3||0.53||0.26||0.39||0.52||0.34|
|Ultra Low Sulfur Diesel||0.29||0.49||0.26||0.35||0.47||0.29|
|High Grade Copper||0.31||0.29||0.16||0.15||0.19||0.25|
Source: Bloomberg Professional (AD1, CD1, BR1, PE1, RU1, RA, SIR1, CL1, HO1, XB1, GC1, SI1, PL1, PA1, HG1, C 1, S 1 W 1, TIO1 and LB1), CME Economic Research Calculations
These correlations offer opportunities for investors who have exposure to either currencies or commodities. For example, one could take a position in a commodity and potentially reduce portfolio risk by taking an opposite position in a positively-correlated currency (Figures 2-5). What makes this even more interesting is the chasm between the carry in currencies and commodities. Some currencies, notably those of emerging markets, exhibit positive interest rate carry versus the U.S. dollar (USD) and other developed market currencies. By contrast, certain commodities exhibit negative carry when they are in contango (when prices in the future are above current levels), a situation that persists much of the time. Essentially, holders of emerging market currencies usually receive an interest rate premium while holders of commodities most often pay storage, insurance, interest and incidental costs.
Calculating currency carry is simple: it’s essentially the interest rate differential between two currencies that accrues over time. Almost all emerging market currencies pay more in interest rates than the U.S. dollar (USD), giving them a positive carry. Positive carry enhances the upside return on upward moves in the spot currency, while buffering losses on downside moves. The ruble is a great case in point: it has fallen 60% versus the USD in spot terms over the past decade, but with the carry reinvested, it has only fallen by about 10% (Figure 6).
It’s an even more dramatic story for the Brazilian real: it has fallen by about 45% over the past decade in spots terms but has risen by more than 50% when accounting for currency carry (Figure 7). In a similar vein, the South African rand’s (ZAR) spot rate has fallen by 60% versus USD since 2006, but an investor who remained long futures or invested ZAR in an interest-bearing account would have only lost 20% over the same period (Figure 8).
For other currencies, the story is less dramatic. In the spot market, the Mexican peso would have lost about half of its value since 2006, but an investor who owned the Mexican peso and received Mexican deposit rates while paying U.S. deposit rates would have lost only 20% over the same period (Figure 9).
Interest rate differentials between USD, AUD and CAD are much smaller. U.S. rates are now above Canadian rates and may soon be above those in Australia. That means that CAD carry is negative versus USD at the moment and barely positive for AUD. As such, one doesn’t get much of a buffer in the event that AUD or CAD fall in value versus USD, nor if they rise (Figure 10).
Unlike currencies, commodities don’t pay interest. Moreover, commodities must be stored, sometimes at significant cost. When a commodity’s forward price curve is positively sloped (future prices are higher than the spot price), it is said to be in contango, which implies negative carry. Unfortunately for buy-and-hold commodity investors, most commodity markets are in contango most of the time. Oil is a great example of this (Figure 11) and it’s true of other energy products and, to a lesser extent, metals and agricultural commodities (Figures 12-14).
Given that the commodity export currencies tend to 1) be positively correlated with commodity markets and 2) tend to have positive carry whereas commodities often display negative carry, should one be just long the commodity export currencies and short commodities to hedge? It’s an interesting question and a risky strategy. Here are factors to consider before taking that path:
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.
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